Wednesday, March 7, 2012

My blog post suggesting that small-cap stocks were mostly to be avoided roused the animosity of many readers. The problem was that many of my readers see themselves as value investors. A surprising number run small funds and my post was an attack on their world view.

Their logic is that it is impossible for a small fund manager to add value by analysing Hewlett Packard*, Vodafone*, Google* or Total* but by being small and diligent and nimble they can add value by picking small caps. They tell themselves (and possibly their clients) this story every day - it brings meaning to their life. They can add value. By saying just avoid small caps I was asserting that their rationalizations were bullsh-t. No wonder they bristled.

My restrictions were somewhat limited - I was only wanting to avoid buying small caps where the possibility of a go-private transaction was underpinning the price. In other words small caps in safe jurisdictions with good balance sheets and open registers were mostly to be avoided. Private equity mostly can not or will not buy financial institutions (with rare exceptions such as JCFlowers) - and there is some value in smaller financials. Likewise some companies that are already so levered that a debt-financed private equity bid is impossible are potentially interesting. Some German two-class-of-shares mid-caps are also interesting. But even these are at best partial exceptions to my rule of small caps being relatively expensive.

Still the rationalizations of the small cap value managers reminded of Woody Allen's zinger about rationalizations being more important than sex. "When was the last time you went 24 hours without a rationalization?"

One of my readers points out just how cheap it looks relative to potential. He figures the pain (and there has been considerable pain) is more or less over and the stock should race. Without a lot of work I can't even express an opinion on that.

But I will note that the first question when analysing a business is "what will they look like in three, five, ten years". Warren Buffett tells us that when he buys businesses he likes to look out decades. I am a little more flighty than that (and I can always dump the stock) so I tend to look 3-5 years out. Call it the "Wayne Gretzky school of value investing" - look at where the puck is going to be and ask if it is cheap against that.

And when you look out three to five years the biggest determinant of how they will look is what the competition will do to them.

Whatever: on this metric SuperValu is difficult. The grocery market is not growing much in aggregate in the US except through food inflation. And the competition at the bottom end is fierce. I would rather wrestle grizzly bears than compete head-to-head with Walmart. And at the top end the competition is also evil. (The Wholefoods store in Chicago where I irregularly shop is very nice. Certainly nicer than the average Albertsons.)

Sales are going backwards. That does not look like it is going to change - although plausibly the rate of decline may drop. This unquestionably a difficult story where a strained company is fighting with superior competitors. When small caps are cheap (and they do get there fairly regularly) there is no need to take on difficult stories. When to find value you need to go headlong into difficult stories then you are probably deluding yourself about there being value there in any general sense (although there may be value in specific instances).

The focus on SuperValu (a truly difficult story) was confirmatory of my view that on-average small caps are particularly difficult at the moment. [I should note however that SuperValu is something that would not appeal to most debt-funded private equity shops. The company is shockingly levered - and my general restriction against small-caps does not apply here.]

Metrics

I have a few metrics I think about with grocers. The main one is EV (meaning market cap plus debt) to sales. My rough rule of thumb is that an EV to sales of under 0.25 is outright cheap (and only seen either when the whole market is distressed or an individual company is distressed). You have to have a very high quality company to want to pay more than 0.5 times sales. These numbers have to be adjusted for retailers that own much of their property (Walmart, Tesco).

The logic is as follows: grocery retailing is a 5 percent margin business give or take a bit. $100 of sales at an EV to sales of 0.5 is $50 of EV. That $50 of EV would have $5 of operating profit associated with it (5 percent margin on $100 of sales). Now imagine the company had no debt and thus no interest bill. Take out tax at 30 percent and you have $3.50 in after tax earnings. That is for $50 of EV (which in this case is $50 in market cap). The price earnings ratio would be just over 16.6.

To pay more than 0.5 times sales you have to argue that unlevered this company is worth more than 17 times earnings. That is possible if there is a lot of growth potential or the margins are sustainably fat. But 0.5 times sales is a price above which I need to be finding rationalizations to maintain my interest.

When non-distressed grocers with solid market positions trade at 0.25 percent of sales (which is very rarely) they are half that price which is cheap by most measures.

The last SuperValu balance sheet had $396 million of short term maturities and $6.2 billion in long term debt. There is a couple of hundred million in cash - which is such a minimal number I am going to ignore it. (There is 200 thousand dollars cash per store - a number that looks small relative to obvious cash needs including just balances in the till.)

$6.5 billion in debt give or take a little. The market cap is 1.35 billion according to Yahoo! EV is thus 7.8 billion. Last year sales were something like 37 billion (and on a very steep decline of about 10 percent per annum). This year they will be something like 35 billion. EV to sales is just over 0.2 - and will be probably close 0.25 when (and if) they can stabilize sales. This is the bottom end of my EV to sales range but is not an outright distress type figure. Given most this EV is debt I would not be much interested in the debt at par (even though it yields 8 percent). That seems like not much upside and in distress this retailer is going to be worth less than 0.25 times sales.

If perchance the debt were to trade at 70c - implying an EV to sales in the mid-teens - then I might get interested in the debt.

The equity is another issue - one I address below.

My second metric for retailers is how much of a lean they are taking on suppliers. Grocers sell stuff fast - many sell their stuff faster than they pay the suppliers meaning they get free funding from them. If they get into trouble (or they want the cheap finance) they let their supplier obligations blow out. I wrote a post once about an Australian wholesaler (Davids Holdings) which let its supplier obligations blow out and nearly went bust. Not nice.

A rough rule of thumb is as follows. Most suppliers give you 30 day terms. If your payables are more than 30 days of sales you are taking a lean on your suppliers. If you take too big a lean they start getting stroppy and ask for cash-on-delivery or letters of credit or the like. Too much of a lean is pretty tightly defined: most grocers have payables of about 35 days of sales.

In the above table payables are 2.7 billion. That is less than a month of sales - SuperValu is clean on this measure. However note that the accounts payable have gone up as sales have gone down. Whilst the level is not a sign of distress the direction is not good (the reduction of debt is not as impressive as it looks).

Finally - and this is the measure that most bugs me - inventory turn is falling. Inventory is up year on year. Sales are down. For a grocer this is unremittingly bad news. Not only are they using capital less efficiently (getting less aggregate margin per square foot for instance) but slowly and surely the store is turning into one of those places you shop only if you like your groceries pre-packaged and just a touch stale.

Whatever - on the numbers as given this is not that cheap relative to EV and the metrics are going the wrong direction.

You could add - and one of my readers did - that the company is underspending on stores. Tired old stores with slow inventory turns and stale product - that is not the way to take on Whole Foods. And unless you are going to shave margins to nothing it is hardly a way to take on Walmart.

If I had to make a bet on this my guess is that it will have to restructure in some form. This might be a sale (for debt reduction) of a large part of the business or it may be Chapter 11. Whatever - this is not easy and not an obvious value stock.

Would I short the stock?

There is a big short interest in the stock. I think the company is probably going to continue to have a rough time. I am a short seller. The obvious question is "would I short the stock?"

Here the answer is surprisingly no. The company in aggregate is not cheap (EV to sales is going to wind up somewhere near 25 percent) but the equity is cheap. Why? Well if things go right (and things always can go right) and the company gets say 100bps more margin - then the stock looks staggeringly cheap.

There are 35 billion in sales. 1 percent margin increase is 350 million per annum. That is very meaningful relative to a market cap of $1.3 billion. Add in a big short interest and the stock could be very strong.

The leverage that makes this whole thing problematic works both ways. If the management can right this ship the stock could be a big winner.

Have the management done a good job

My bullish commentator thinks the management have done a good job. As far as I can tell he is right. They have shrunk the business (a lot), paid off a lot of debt, and it appears been pretty straight-up-and-down about it. I am a little irked by the falling turnover (it will make the product stale) but that might just be the hand they were dealt.

I have not done a lot of work. I have not walked around these stores. I have not done any apple-freshness tests. But on the numbers I see no reason to believe management have not been pretty good.

That is a blessing and a curse. Good management will be necessary to salvage this situation. But if these stores have been well managed then getting a new broom in can't save the situation. You have to play the cards that are dealt.

Summary

If SuperValu is proof that there is value easily detectable in companies under $5 billion in market cap then - frankly - I think I will take my large caps.

I would not be long this without tangible on-the-ground evidence (from surveying up to 30 stores in different locations) that this really has turned around. Because at the moment this does not pass the Wayne Gretsky test of value. In five years it looks really really bad.

And I would not be short it either with that leverage without a decent understanding of their day-to-day liquidity and just how short-dated the situation is.

This one belongs in the too-hard basket. And half a day is wasted looking at another stock that ultimately I don't care about.

John

*For disclosure purposes we were once short Hewlett Packard but have covered, we are long Vodafone and Google - two of our biggest positions, and we were once long Total but have sold.

17 comments:

Anonymous
said...

Analysis makes a lot of sense - thanks for the note. A couple notes i might add to show how competitive this business is. Kroger is a terrific operator...great comps, consistently low pricing, great mgmt and guess what? the stock does nothing. They have to re-invest all the gross margin growth back into lower prices. Also, in the conventional grocery space, you are competing with the Costco's, BJ's and even the Targets now that are slipping in. Those folks are much more price competitive. It seems you want to be at the high (Whole Foods or TFM) or low end (Club guys seem to high strong comps). Guys in the middle are struggling from continued new entrants and pricing. I think SVU has a good CEO, just an incredible uphill battle to climb. Very difficult to juggle that debt-load, high store prices and declining sales. On your point regarding what this will look like in 3 years or so..how does anyone know what the real ebitda is? we know their prices are way above mkt in their conventional stores. If they can't find more cost take-out, ebitda could fall a fair bit and then you are bumping up against covenants.

One thing that is completely insane is the dividend. Why are they paying a dividend? Over the last 3 years they could have payed off another $250-$300mm in debt. No one is in this name for the divvy.

Your first post had two threads: (1) does a potential private equity bid drive up all small-cap stock prices, and (2) are small-caps too expensive such that one should only look in large caps.

You, like me and my partner, are an extremely strong "N" on the Myers-Briggs scale; we tend to use a few data points we already have to reason out how the world "should" be, rather than go out and gather a thousand data points detailing how the world "is." And lo, it usually works, if you're good at the reasoning part.

But not always. In this case, you used reasoning on #1 above to make a flat generalization on #2. It didn't work. We, like you, have a long book that is currently dominated by large caps, because they are cheap as a group. But our book also includes a nice collection of out-of-the-way small caps that are cheap -- in some cases, stunningly cheap. I don't need to worry whether a real or imagined PE bid is making them less cheap than they otherwise would be; they are more than cheap enough, even after adjusting for business risk or stock liquidity or whatever you want.

These small-caps are not the SuperValus of the world. SVU is covered by at least 15 sell-side shops. For "stunningly cheap," you usually need stocks that almost no one has heard of.

Most of this small cap argument is a mis-communication. There are 2 different statements.

1) "Small caps on average are not attractive at the moment." John and company agree, as do I (a small cap manager).

2) "You can find value in small caps at the moment." I think this is true, and I'm guessing most agree with me. I rejected SVU as too difficult after 5 minutes. This is not a good example of easy value IMHO. (I probably have less money than most on this board, so I can look at $20M to $50M mkt cap companies. SVU is huge to me.)

There is no contradiction between 1 and 2. Sure is fun to watch everyone fight though.

Think I agree with Tom that some mis-communication was in play here. Just based on average prices small caps seem to be expensive at the moment (GMO's asset class forecast is imo a good sanity check), and think a lot of people would agree with this statement.

I think most people had more a problem with the PE argument, as it also would imply that small caps as a group would almost never be attractive as long as those guys are around.

Thanks for the detailed follow-up John. Sorry we didn't bring up something that was investable, but it's always worth thinking about the grocery industry so we're ready when it gets properly cheap.

Anon: You're right that the dividend is insane. I see it as a signal that management is interested in pretending along with investors that this company is not over-leveraged and has adequate cash-flows to pay shareholders consistently. You will note that whenever someone starts losing an argument on cash-flows & valuation re: this type of company, they resort to "But it pays a 5% dividend! That's money in your pocket! There's no way they will cut it further! Even if the stock goes nowhere, you make 5%!" Then the price craters and they cut the dividend. We saw it with Citi, BofA, GE, etc. Funny that this lot never admits error or integrates subsequent dividend cuts in their favorite stocks into their thinking.

John, thanks for sharing your notes and commentary on the industry. I was looking for some projects for summer interns, and this will be a great introduction for them in how to make the broad sweeps on a stock and sector.

Hopefully we'll connect up some day in either Chicago or Sydney, as I live in the former and occasionally visit the latter. I am a big fan of the blog.

To be concrete, the kinds of small caps that I have found attractive in the past couple years include FRD and CNRD which are still only trading around P/E ~ 5x (excluding cash) after having run up 100%+ since 2010. To me, these were very low risk since they both had shareholder oriented management with lots of cash and historically profitable operations.

The trick is to avoid the sketchy small caps - and they are the majority. I'm guessing that you can't look for things like FRD and CNRD because you're too big for it to be worth your while. But, that is exactly the point. Small cap managers have an advantage. Whether they can utilize that advantage is another question. There are still some companies like this out there - but they are harder to find than in 2010.

I love your passionate responses - they are entertaining and almost always on the mark. Keep up the great blog.

On average small caps may not be cheap. But, my question to anyone here is why does it matter so much. Are we looking to buy entire indexes? Or just pick stocks one at a time..wherever they may be..and however small or large they may be.

Here is an article from Royce which addresses the main question of the posts. Large Cap valuation v/s Small Cap valuations. I think its a good read.

Small critique. It is slightly misleading to compare December 3, 2011 to February 26, 2011 when comparing Inventory and A/P for the simple fact that grocery stores load up on Inventory for the holiday season as this is the busiest time of year for them. Year over year comparison would be much better and then if the fact still holds true, point well taken.

Funny you should mention SVU (an appropriate ticker symbol). I glanced at it a few months ago, it seemed interesting, and I bought a trivial amount of in the money LEAPS to tide me over while I did more rigorous research (a bad habit born of good intentions: the surest incentive to do work is money already on the table). Then I basically went through an accelerated grieving process:

Denial: "I understand this co completely, and nobody else does."

Anger: "Why is it so cheap? This is ridiculous."

Bargaining: "If it just can improve comps a tiny bit, the price is going to the moon."

Depression: "This sucks."

Acceptance: "I'm not smart enough to figure out whether they can turn it around. Management is smarter than I am, but I suspect they don't know the answer to this either."

With that, I sold the LEAPS at a miniscule profit, though losing money would have been more appropriate.

I think that the problem with a lot of "cheap" smaller companies is that they need them wave of a fairy wand to make them realize their potential: comps need to improve for no reason, products need to catch on despite being equivalent to competitors', white elephants need to surprise everyone, etc. Just one thing (usually) needs to go right, and you've tripled your money. Tripled! Compared to whatever you can get in VOD or GE or ____!

This "big score" thinking is a problem, I think, because it tends to narrow an investor's focus; one tends to check on whether the key wave-wand is imminent and ignore a host of other factors. Nobody buys megacaps for a big score (though they sometimes get it; hello, AAPL), and there are many ways one can be myopic with larger cos as well, but one does tend to buy them for what they are, not what the might one day be if everything breaks their way. Maybe lg-cap investing is peering into the future, and small-cap investing (at times like these, anyway) is doing so with rose-colored glasses.

That (excessively) said, I make my living (such as it is) mostly on smaller companies, though they tend to be microscopic, financials, or both.

Hi John. Been following your blog for over a year now and enjoy reading individual company analysis. I looked at this companys bonds last year and passed on them. The company is too leveraed so any freezing again in the credit market in the future may docs them into Ch.11

Also my other problem is that the company does not seem to really have a turnaround future despite managements best efforts. They are not in the best financial condition to take on big competitors. This reminds me of Sprint which decided to go 'all in' with the iPhone and assumed enormous amounts of debt they cannot afford.

I got burned by sprints bonds last year. So living credit line to credit line isn't a investment strategy for me.

missed this the first time through but nice post. And just for future reference, I think you have wrongly attributed the line "Have you ever gone 24 hours without a rationalization." The line was in the Big Chill and I'm pretty sure it originated there.

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The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.